SIMPLE IRA vs. Traditional IRA: How to Choose the Right Plan

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SIMPLE IRA vs. Traditional IRA: How to Choose the Right Plan – Planning for retirement is a critical aspect of financial well-being, and Individual Retirement Accounts (IRAs) play a vital role in that process. IRAs offer individuals and small businesses various options to save and invest for retirement.

Among the different types of IRAs available, two popular choices are the SIMPLE IRA (Savings Incentive Match Plan for Employees) and the Traditional IRA. Understanding the differences between these two types of retirement accounts is crucial in making informed decisions about your financial future.

In this article, we will explore the features, benefits, and considerations of both the SIMPLE IRA and Traditional IRA, helping you determine which one aligns best with your needs and goals.

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What is a SIMPLE IRA and how does it work

A SIMPLE IRA stands for Savings Incentive Match Plan for Employees. It is a type of retirement plan that is set up by small business owners for themselves and their employees. A small business is defined as one that has up to 100 employees who earned at least $5,000 in the previous year.

A SIMPLE IRA works like this:

  • The employer sets up a SIMPLE IRA account for each eligible employee and makes contributions to it on their behalf.
  • The employee can also make elective salary deferral contributions to their own account, up to a certain limit per year.
  • The employer can choose to match the employee’s contributions dollar for dollar, up to 3% of their compensation, or make a fixed contribution of 2% of their compensation, regardless of whether the employee contributes or not.
  • The contributions are made with pre-tax money, which means they reduce the employee’s taxable income for the year.
  • The money in the account grows tax-deferred until the employee withdraws it in retirement, at which point it is taxed as ordinary income.

What is a traditional IRA and how does it work

A traditional IRA is a type of retirement plan that is set up by an individual who has earned income during the year. Anyone who meets this requirement can open and contribute to a traditional IRA, regardless of their age or employment status.

A traditional IRA works like this:

  • The individual set up a traditional IRA account with a financial institution of their choice and makes contributions to it on their own behalf.
  • The individual can contribute up to a certain limit per year, depending on their age and income level.
  • The individual may be able to deduct some or all of their contributions from their taxable income for the year, depending on their income level and whether they or their spouse are covered by another retirement plan at work.
  • The money in the account grows tax-deferred until the individual withdraws it in retirement, at which point it is taxed as ordinary income.

How to compare SIMPLE IRA vs. traditional IRA

SIMPLE IRA and traditional IRA have some similarities and some differences that you should consider when comparing them. Here are some of the main factors to compare:

Contribution limits

One of the main differences between SIMPLE IRA and traditional IRA is the amount of money that you can contribute to them per year.

In 2022, the contribution limit for a SIMPLE IRA is $14,000 if you are under 50 years old, or $17,000 if you are 50 or older. This limit includes both your salary deferral contributions and your employer’s matching or fixed contributions.

In 2022, the contribution limit for a traditional IRA is $6,000 if you are under 50 years old, or $7,000 if you are 50 or older. This limit applies only to your own contributions; there are no employer contributions for a traditional IRA.

In 2023, the contribution limit for a SIMPLE IRA is $15,500 if you are under 50 years old, or $19,000 if you are 50 or older.

In 2023, the contribution limit for a traditional IRA is $6,500 if you are under 50 years old, or $7,500 if you are 50 or older.

As you can see, a SIMPLE IRA allows you to contribute more money per year than a traditional IRA, especially if your employer matches your contributions. However, this also means that you will have more money taxed as ordinary income when you withdraw it in retirement.

Employer contributions

Another major difference between a SIMPLE IRA and a traditional IRA is whether your employer makes contributions to your account or not.

For a SIMPLE IRA, your employer is required to make contributions to your account, either by matching your contributions up to 3% of your compensation or by making a fixed contribution of 2% of your compensation. This means that you can get free money from your employer to boost your retirement savings.

For a traditional IRA, your employer does not make any contributions to your account. You are solely responsible for funding your retirement plan.

Employer contributions can be a great benefit for a SIMPLE IRA, as they can increase your retirement savings without increasing your tax burden. However, they also come with some strings attached, such as vesting rules and withdrawal penalties.

Tax deductions

Another factor to compare between SIMPLE IRA and traditional IRA is whether you can deduct your contributions from your taxable income or not.

For a SIMPLE IRA, you cannot deduct your contributions from your taxable income, because they are already made with pre-tax money. However, you can reduce your taxable income by the amount of your salary deferral contributions, which means that you will pay less income tax for the year.

For a traditional IRA, you may be able to deduct some or all of your contributions from your taxable income, depending on your income level and whether you or your spouse are covered by another retirement plan at work. If you can deduct your contributions, you will pay less income tax for the year. If you cannot deduct your contributions, they are considered non-deductible contributions, which means that you will not pay tax on them when you withdraw them in retirement.

Tax deductions can be a valuable benefit for a traditional IRA, as they can lower your tax bill for the year and increase your after-tax savings. However, they are subject to income limits and phase-outs, which means that not everyone can take advantage of them.

Withdrawal rules

Another aspect to compare between SIMPLE IRA and traditional IRA is the rules for withdrawing money from your account in retirement or before.

For a SIMPLE IRA, you can start withdrawing money from your account without penalty when you reach age 59 1/2. However, if you withdraw money within the first two years of participating in the plan, you will have to pay a 25% penalty on top of the ordinary income tax. This penalty is reduced to 10% after the first two years. You can also withdraw money before age 59 1/2 without penalty if you meet certain exceptions, such as disability, death, medical expenses, first-time home purchase, higher education expenses, or IRS levy.

For a traditional IRA, you can start withdrawing money from your account without penalty when you reach age 59 1/2. If you withdraw money before age 59 1/2, you will have to pay a 10% penalty on top of the ordinary income tax, unless you meet certain exceptions, such as disability, death, medical expenses, first-time home purchase, higher education expenses, IRS levy, or substantially equal periodic payments.

For both SIMPLE IRA and traditional IRA, you have to start taking required minimum distributions (RMDs) from your account when you reach age 72. These are the minimum amounts that you have to withdraw from your account each year based on your life expectancy and account balance. If you fail to take RMDs, you will have to pay a 50% penalty on the amount that you should have withdrawn but did not.

Withdrawal rules can affect how much money you can access from your account and how much tax and penalty you have to pay on it. You should be aware of these rules and plan accordingly for your retirement income needs and goals.

Conversion options

Another difference between a SIMPLE IRA and a traditional IRA is whether you can convert them to another type of retirement plan or not.

For a SIMPLE IRA, you cannot convert it to another type of retirement plan while you are still working for the same employer that set up the plan. However, after two years of participating in the plan, you can roll over or transfer your account balance to another type of retirement plan, such as a traditional IRA or a Roth IRA. If you do so, you will have to pay tax on the amount that you roll over or transfer, unless it is to another pre-tax plan.

For a traditional IRA, you can convert it to another type of retirement plan at any time. The most common conversion is to a Roth IRA, which is a type of retirement plan that allows you to contribute after-tax money and withdraw it tax-free in retirement. If you convert your traditional IRA to a Roth IRA, you will have to pay tax on the amount that you convert in the year that you do so. However, this may be beneficial if you expect to be in a higher tax bracket in retirement or if you want to avoid RMDs.

Conversion options can give you more flexibility and control over your retirement savings and taxes. However, they also involve some costs and risks that you should consider carefully before making any decisions.

Frequently Asked Questions (F&Qs) SIMPLE IRA vs. Traditional IRA

Is traditional IRA the same as SIMPLE IRA?

No, Traditional IRA and SIMPLE IRA are not the same. Both are individual retirement accounts (IRAs), but they have different rules and regulations.

What are the 3 types of IRA?

here are three main types of IRAs:

  • Traditional IRA
  • Roth IRA
  • SEP IRA

What is the limit on a SIMPLE IRA vs traditional IRA?

The contribution limits for SIMPLE IRAs and traditional IRAs are different.

SIMPLE IRA

  • Employee contribution limit: $15,500 in 2023.
  • Employer contribution limit: $31,000 in 2023.

Traditional IRA

  • Individual contribution limit: $6,000 in 2023.
  • Married couple filing jointly contribution limit: $12,000 in 2023.

Catch-up contributions

  • Individuals age 50 and older can contribute an additional $1,000 to a SIMPLE IRA or traditional IRA.

Combined contribution limits

  • If you participate in both a SIMPLE IRA and a traditional IRA, the total contribution limit is $22,500 in 2023 for individuals and $33,000 for married couples filing jointly.

High earners

  • If you are an eligible employee of a company that offers a SIMPLE IRA and your income exceeds certain limits, you may not be able to deduct your contributions on your taxes.
  • If you have an income above certain limits, you may not be able to contribute to a traditional IRA.

How much money can I put in a SIMPLE IRA?

The maximum amount of money you can contribute to a SIMPLE IRA in 2023 is $15,500. If you are age 50 or older, you can make an additional catch-up contribution of $3,000, for a total of $18,500.

What is the maximum for traditional IRA?

The maximum contribution limit for a traditional IRA in 2023 is $6,000. If you are 50 years of age or older, you can make an additional catch-up contribution of $1,000, for a total of $7,000.

Who is eligible for a traditional IRA?

Anyone can open a traditional IRA, but not everyone is eligible to deduct their contributions on their taxes. The eligibility requirements for deducting contributions to a traditional IRA are based on your modified adjusted gross income (MAGI).

What are the benefits of traditional IRA?

There are several benefits to contributing to a traditional IRA. Here are a few of the most important ones:

  • Tax-deferred growth
  • Employer matching contributions
  • Flexibility
  • Portability
  • Inherited IRAs

When can you withdraw from IRA?

ou can withdraw money from an IRA at any time.